The Rise of Shadow Banking (1) – From ‘Originate-to-hold’ model to ‘Originate-to-distribute’ model

Ever think of being a bank without actually being a bank? It might sound a bit confusing but put it differently, operating like a bank without being regulated by the central bank and relevant regulators. Yes, it is possible. Every high street bank you see right now is subject to regulations. In the UK for instance, the banks are regulated by Financial Conduct Authority and must have deposit insurance to safeguard the depositors’ money (through Financial Services Compensation Scheme). With the regulations getting more stringent, it reduces banks’ flexibility (also increases the cost of compliance) which has resulted in financial system shifting from ‘Originate-to-hold’ model (OTH) to ‘Originate-to-distribute’ model (OTD).

In the OTH model (conventional), the banks grant credits (known as loans) to individuals and corporates. The loans will be booked in the assets and sit in the balance sheets until it matures and fully repaid. The assets are income generating (through interest payments). However, there exist risks of default. The loans failed to recover will be wiped off against the equity. Imagine a bank has an asset of RM 10 against equity of RM 1, leverage of 10x. 10% reduction in assets (through bad loans) will wipe out the entire equity; further deterioration will leave the liabilities (the depositors for instance) insolvent. Therefore, to protect the depositors (liability side of the balance sheet) and avoid banks become excessive levered; it is subject to capital requirements (the amount of capital the banks require to hold). Riskier loans require higher capital which represents a cost, and the banks must also ensure it meets certain criteria before dividend distribution as it will weaken the capital position. Due to many restrictions, it has resulted in the rise of OTD model.

In the OTD model, the banks act as a financial intermediary, linking the supply of capital with the demand. For example, Maxis (a Malaysian telecom company) wants to raise money; it approaches CIMB (a Malaysian bank) for a loan of, say RM 100 billion (to make it unrealistic). CIMB might not want to expose to too much risk or overly concentrate to Maxis (as the default will cripple CIMB’s capital). What it could do is, it could go to the market and seek investors interested in providing the capital. Financial Institutions (such as RHB and Maybank) might be interested. There could also be non-bank financial institutions (such as hedge funds, asset managers or even pension funds) with capital to invest but do not have banking licenses. So, CIMB could earn arrangement fee for originating the loan and sell the loan (may be in tranches) to institutional investors rather than holding it on the balance sheet which is subject to the capital requirement. Now, it frees up CIMB’s capital, and now they can go out to find more deals and earn more fees on origination (which is arguably, less risky than holding it on the balance sheet until the loans mature). This is not the only method to distribute as we will explore more in the future.

The problems with OTH model (the list is not exhaustive)1) Maturity mismatch – Borrow short-term to fund long-term lending is challenging. It needs to consider the liquidity issues and matching the duration of assets with the liabilities to ensure no mismatch and leave the surplus to be actively managed.2) Default risk – Traditional banks are highly leveraged and with leverage as high as possibly 10x of its equity. The leverage magnifies both losses and profits thus; it is a double-edged Banks are in the business of when it wins; it wins small. When it loses, it loses big.3) Capital requirements – The banks must ensure the compliance of relevant regulation governing capital requirements and the compliance is very costly. The banks need to consider the amount of capital they have before they grant any credits. Imagine a bank with a capital of RM 10; it is less likely to have a loan book of RM 10,000. Of course, not all loans exhibit the same risks.

How OTD model overcome the limitations of OTH model?By selling the loans to the third party, the banks are no longer required to hold the loans hence it solves the three problems which we have just discussed. The reason is simple. The loans no longer sit on the balance sheet, thus there is minimal need to consider the default risk, capital requirement and balancing long term assets with short term liabilities.

With the assets under management of non-bank financial institutions growing exponentially. It has led to the higher demand for financial assets to satisfy investors’ hunger for yield. When the banks started to feel the regulatory pressure, it will explore other opportunities to continue its business.

SummaryThere are many complicated issues to be considered in both models. OTD model can be argued that it increases the likelihood of moral hazard and adverse selection problems. The banks are no longer focus too much on the creditworthiness (even though they may argue this is not necessarily true) or lower their standard in selection. Either way, the rise of OTD has changed the landscape of banking industry. To some degree, may lead to greater power to the borrowers as they can now approach to these non-bank financial institutions for credit instead of conventional banks.